An independent Scotland’s currency options

Whether an independent Scotland chooses being part of a sterling currency union, adopting the euro or having an independent currency if it votes to split from Britain next year, the choice will depend on the level of debt it inherits.

How much of the existing UK public debt an independent Scotland would inherit, and how it manages its debt are central to understanding its currency choices, suggests research from the National Institute of Economic and Social Research (NIESR).

Dr Angus Armstrong, director of macroeconomic research at the NIESR, and colleague Dr Monique Ebell, NIESR research fellow are being funded by the Economic and Social Research Council (ESRC) to look at the currency and fiscal options for Scotland as part of the ESRC’s Future of the UK and Scotland initiative to inform the referendum debate.

It found that it wouldn’t matter which currency option an independent Scotland chose, but said instead the verdict requires deciding which criteria are most important.

The NIESR researchers put their emphasis on fiscal solvency – whether a country can honour its debt obligations.

“Recent events around the world, particularly in Europe, have shown that fiscal sustainability and currency arrangements cannot be considered in isolation,” said ESRC fellow Dr Armstrong.

“We consider how the existing UK public debt would be divided and the ability of an independent Scotland to pay its share. For an independent Scotland to prosper it requires a ‘hard’ currency; one in which investors are willing to hold long-dated Scottish government debt at a reasonable price. A necessary condition for a ‘hard’ currency is that government solvency must always be beyond doubt.”

The team addressed two key issues: how much higher would an independent Scotland’s borrowing costs be if it keeps using sterling and what sorts of fiscal policy would be consistent with debt stabilisation.

The researchers estimated that an independent Scotland would face additional interest rate costs of between 0.72% to 1.65% above the UK borrowing costs for 10-year debt (or technically a spread of 72 to 165 basis points over the average 10 year UK bond yield of 4.10% between 2000 and 2012).

They also estimated that Scotland would have to run a tight fiscal policy to achieve a sound debt level under those borrowing costs. Using the lower bound borrowing cost, Scotland would need to run primary or underlying surpluses (excluding interest payments) of 3.1% annually order to achieve a Maastricht-defined debt to GDP ratio of 60% after 10 years of independence.

Given Scotland’s estimated average primary fiscal deficit of 2.3% (including taxes from oil and gas) over the period 2000-2012, running a surplus of 3.1% would represent a fiscal tightening of 5.4%.

These estimates assume that Scotland would receive a geographic share of hydrocarbon reserves, a per capita share of existing public sector debt (on a Maastricht basis) and real GDP would grow at 2% annually.

Such a fiscal tightening would leave an independent Scotland with very little room for fiscal manoeuvre in the case of a negative shock, such as a drop in the oil price or a recession, said the report.

That makes it important to have other policies available, such as interest rate or exchange rate adjustment.

Among the currency options open to an independent Scotland, having its own currency would give it flexibility to respond to shocks. While there are significant transitional challenges, over the medium and longer term this would be more consistent with independence.

The team proposed a novel way of reducing the initial debt burden which would leave an independent Scotland looking more like the successful independent Scandinavian countries which also have their own currencies.

“An oil for debt swap – where the oil revenues would pass over to the UK in exchange for a large write down of the debt that Scotland would otherwise assume – would greatly reduce the economic risks of independence, although there may be significant political limitations to this possibility,” suggested the report.

Dr Armstrong said: “The greater the amount of public debt an independent Scotland assumes, the greater the importance of retaining some policy flexibility and the stronger the case for introducing a new Scottish currency.”